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Chapter 2 An Overview of the Financial System

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Page 1: An Overview of the Financial System - Cameron Universitysyeda/ec3313/ch2.pdf · An Overview of the Financial System. Copyright © 2007 Pearson Addison-Wesley. All rights reserved

Chapter 2

An Overviewof the Financial System

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Function of Financial Markets

• Perform the essential function of channeling funds from economic players that havesaved surplus funds to those that have a shortage of funds

• Promotes economic efficiency by producingan efficient allocation of capital, which increases production

• Directly improve the well-being of consumers by allowing them to time purchases better

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Structure of Financial Markets

• Debt and Equity Markets

• Primary and Secondary MarketsInvestment Banks underwrite securities in primary marketsBrokers and dealers work in secondary markets

• Exchanges and Over-the-Counter (OTC) Markets

• Money and Capital MarketsMoney markets deal in short-term debt instrumentsCapital markets deal in longer-term debt and equity instruments

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Internationalization of Financial Markets

• Foreign Bonds—sold in a foreign country and denominated in that country’s currency

• Eurobond—bond denominated in a currency other than that of the country in which it is sold

• Eurocurrencies—foreign currencies deposited in banks outside the home country

Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

• World Stock Markets

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Function of Financial Intermediaries: Indirect Finance

• Lower transaction costsEconomies of scaleLiquidity services

• Reduce RiskRisk Sharing (Asset Transformation)Diversification

• Asymmetric InformationAdverse Selection (before the transaction)—more likely to select risky borrowerMoral Hazard (after the transaction)—less likely borrower will repay loan

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Regulation of the Financial System

• To increase the information available to investors:Reduce adverse selection and moral hazard problemsReduce insider trading

• To ensure the soundness of financial intermediaries:Restrictions on entryDisclosureRestrictions on Assets and ActivitiesDeposit InsuranceLimits on CompetitionRestrictions on Interest Rates

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